Mid-Market Impact on Economic Recovery Continues but May Slow

A RECOVERY AT RISK

The U.S. economy has experienced a tepid recovery so far. After nudging along at a disappointing pace of 1.1% annualized real growth in GDP in the first quarter of 2013, the economy showed some promise when it grew at 2.5% in the second quarter. However, early results for the third quarter suggest an annualized growth rate of less than 2%. Indeed, large firms (those in the S&P 500) saw revenues grow at 2.6% for the past twelve months. Looking ahead the S&P 500 firms are projected to grow revenue at a mere 1%.

In contrast, the middle market has been a shining light in this recovery to date with revenue growth rates typically well above 5%. But the data for Q3 suggests that growth is tapering off. The rate of growth of revenues for the past 12 months was 5.5%. Unfortunately, the latest survey from the National Center for the Middle Market shows that the expected rate of growth of revenues in the middle market is only 4.4% for the upcoming year. When it comes to job creation, the good news is employment grew at a stable rate of 2.8% in Q3. What is less reassuring, however, is that executives predict slower employment growth of 2.1% in the year ahead. The percentage of middle market executives willing to invest an extra dollar, a figure that had been increasing for the previous six quarters, has now dipped from 64% for Q2 to 61% in Q3. Not a large change, but significant because of change in direction. Similarly, the percentage of middle market managers expressing some confidence in the local/regional economy, the main hub of operations for middle market firms, has dipped from 79% in Q2 to 77% in Q3. Altogether, the middle market, thus far an engine of growth in the economy, seems to be "peaking out."

THE ECONOMIC DRAG FROM GOVERNMENT UNCERTAINTY

A clear drag on the economy is the relentless creation of man-made uncertainty, which cannot be good for investment and growth. Within the past year, markets have been roiled by uncertainties arising out of the fiscal cliff (recall the Bush era taxes?), the ongoing saga of sequestration, the threat of government shut down, and debt ceiling debates. A default by the U.S. government on its debt on account of a failure to relax the debt ceiling is the latest potential problem, and it has serious consequences. Currently, the interest rate on U.S. 10-year Treasury bonds is about 2.7%. In other words, we are financing the operations of the U.S. government at very favorable rates. All of us, businesses included, are beneficiaries of the good faith and standing of the U.S. government. A default would surely raise these government interest rates with an impact on other rates, consequently increasing interest costs for businesses. It would also shake the confidence of those around the world that have financed our deficits. An increase in interest rates would automatically lower the value of the bonds now held by the Chinese and the Japanese, for example. Their losses could be enormous, since they hold $1.28 Trillion and $1.14 Trillion of U.S. Treasuries, respectively. Imagine the impact on the willingness of foreign investors to buy U.S. government bonds and on the future borrowing costs to the U.S. government and businesses!

IMPACT OF U.S. DEBT DEFAULT ON MIDDLE MARKET FIRMS

While middle market managers seem to have taken the government shutdown in stride (only 15% say that it will have a negative impact on business), a U.S. default on debt is an entirely different matter. Nearly half of middle market executives surveyed claim that government default would have a negative impact on business. In our survey, they tell us that default can lead to higher interest rates, reduced consumer confidence, reduced confidence among businesses, reduced foreign direct investment, and reduced confidence in the creditworthiness of the country. Some 94% of middle market executives consider higher interest rates as the most adverse impact of a U.S. default on its debt. At the time of this report, the current debt ceiling crisis appears to have been averted. However, ongoing uncertainty in Washington will continue to put pressure on this vital segment of the economy.

In sum, in a cross-sectional comparison, the middle market is doing well relative to other segments. But in an intertemporal comparison, its growth has hit a plateau. Instead of its intended role as a facilitator, government seems to be instead playing the role of spoiler in this case, at a time when the unemployment rate is still hovering around 7.3%